Wednesday, August 26, 2009

So far, we've gone through how to determine what you'll need for retirement, where you can get your retirement savings from, what types of investment accounts you can put your savings into and the benefits of long-term and tax-efficient investing. After all this you may now be asking yourself, "What the heck do I invest in?"

It isn't practical to discuss in detail the wide array of securities and investing strategies available in the market today, but we will go over the basics you'll need to know to set up your retirement investments.

The assets you choose to invest in will vary depending on several factors, primarily your risk tolerance and investment time horizon. The two factors work hand in hand. The more years you have left until retirement, the higher your risk tolerance.

If you have a longer-term time horizon, say 30 years or more until retirement, investing all of your savings into common stocks is probably a reasonable idea. If you are nearing your retirement age and only have a few years left, however, you probably don't want all of your funds invested in the stock market. A downturn in the market a year before you are all set to cash out could put a serious damper on your retirement hopes. As you get closer to retirement, your risk tolerance usually decreases; therefore, it makes sense to perform frequent reassessments of your portfolio and make any necessary changes to your asset allocation.

Generally speaking, if you have a limited time horizon, you should stick with large-cap, blue chip stocks, dividend-paying stocks, high-quality bonds, or even virtually risk-free short-term Treasury bills, also called T-bills.

That said, even if you have a long-term time horizon, owning a portfolio of risky growth stocks is not an ideal scenario if you're not able to handle the ups and downs of the stock market. Some people have no problem picking up the morning paper to find out their stock has tanked 10 or 20% since last night, but many others do. The key is to find out what level of risk and volatility you are willing to handle and allocate your assets accordingly.

Of course, personal preferences are second to the financial realities of your investment plan. If you are getting into the retirement game late, or are saving a large portion of your monthly income just to build a modest retirement fund, you probably don't want to be betting your savings on high-risk stocks. On the other hand, if you have a substantial company pension plan waiting in the wings, maybe you can afford to take on a bit more investment risk than you otherwise would, since substantial investment losses won't derail your retirement.

As you progress toward retirement and eventually reach it, your asset allocation needs will change. The closer you get to retirement, the less tolerance you'll have for risk and the more concerned you'll become about keeping your principal safe.

Risk Tolerance
As we mentioned before the investor risk tolerance and it should be adjusted as you approach the retirement period, it would be wise for you to assess what is your personal preferences in terms of the risk tolerance.

Most investors fall into one of the following categories:

Conservative
You are willing to accept the lowest return potential, lowest return variability and the lowest fluctuation in account value in exchange for lower risk.

Moderately conservative
You are willing to accept a relatively low return potential, relatively low return variability and relatively low fluctuation in account value in exchange for a below average amount of risk.

Moderate
You are willing to accept an average amount of risk in exchange for average return potential, average return variability and average fluctuation in account value.

Moderately aggressive
You are willing to accept an above average amount of risk in exchange for a relatively high return potential, relatively high return variability and relatively high fluctuation in account value.

Aggressive
You are willing to accept the highest amount of risk in exchange for the highest return potential, the highest return variability and the highest fluctuation in account value.

Again, once you understand your risk tolerance, you can construct your asset allocation — the mix of investments in your portfolio. As you approach retirement, you'll want to adjust carefully your asset allocation to help protect you from market risk while retaining potential for growth.

The Importance of DiversificationThere are countless investment books that have been written on the virtues of diversification, how to best achieve it and even ways in which it can hinder your returns.

Diversification can be summed in one phrase: Don't put all of your eggs in one basket. It's really that simple. Regardless of what type of investments you choose to buy - whether they are stocks, bonds, or real estate - don't bet your retirement on one single asset.

As you contribute savings to your retirement fund month after month, year after year, the last thing you want is for all your savings to be wiped out by the next Enron. And if there's anything we have learned from the Enrons and Worldcoms of the world, it's that even the best financial analysts can't predict each and every financial problem.

Given this reality, you absolutely must diversify your investments. Doing so isn't really that difficult, and the financial markets have developed many ways to achieve diversification, even if you have only a small amount of money to invest.

Diversification Approaches

A diversified portfolio should be diversified at two levels: between asset categories and within asset categories. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you'll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions.

One of way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. But the stock portion of your investment portfolio won't be diversified, for example, if you only invest in only four or five individual stocks. You'll need at least a dozen carefully selected individual stocks to be truly diversified.

Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset category through the ownership of mutual funds rather than through individual investments from each asset category. A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, and other financial instruments. Mutual funds make it easy for investors to own a small portion of many investments. A total stock market index fund, for example, owns stock in thousands of companies. That's a lot of diversification for one investment!

Be aware, however, that a mutual fund investment doesn't necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. If you invest in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get the diversification you seek. Within asset categories, that may mean considering, for instance, large company stock funds as well as some small company and international stock funds. Between asset categories, that may mean considering stock funds, bond funds, and money market funds. Of course, as you add more investments to your portfolio, you'll likely pay additional fees and expenses, which will, in turn, lower your investment returns. So you'll need to consider these costs when deciding the best way to diversify your portfolio.

Portfolio Rebalancing

Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time some of your investments may become out of alignment with your investment goals. You'll find that some of your investments will grow faster than others. By rebalancing, you'll ensure that your portfolio does not overemphasize one or more asset categories, and you'll return your portfolio to a comfortable level of risk.

For example, let's say you determined that stock investments should represent 60% of your portfolio. But after a recent stock market increase, stock investments represent 80% of your portfolio. You'll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to reestablish your original asset allocation mix.

When you rebalance, you'll also need to review the investments within each asset allocation category. If any of these investments are out of alignment with your investment goals, you'll need to make changes to bring them back to their original allocation within the asset category.

There are basically three different ways you can rebalance your portfolio:

You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.

You can purchase new investments for under-weighted asset categories.

If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.

Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger transaction fees or tax consequences. Your financial professional or tax adviser can help you identify ways that you can minimize these potential costs.

You can rebalance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing.

Others recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you've identified in advance. The advantage of this method is that your investments tell you when to rebalance. In either case, rebalancing tends to work best when done on a relatively infrequent basis.

Active Vs. Passive Management
Consider buying mutual funds or exchange-traded funds (ETFs), if you are starting out with a small amount of capital, or if you aren't comfortable with picking your own investments. Both types of investments work on the same principle - many investors' funds are pooled together and the fund managers invest all the money in a diversified basket of investments.

This can be really useful if you have only a small amount of money to start investing with. It's not really possible to take $1,000, for example, and buy a diversified basket of 20 stocks, since the commission fees for the 20 buy and 20 sell orders would ruin your returns. But with a mutual fund or ETF, you can simply contribute a small amount of money and own a tiny piece of each of the stocks owned by the fund. In this way, you can achieve a good level of diversification with very little cost.

There are many different types of mutual funds and ETFs, but there are two basic avenues you can choose: active management and passive management. Active management refers to fund managers actively picking stocks and making buy and sell decisions in attempt to reap the highest returns possible

Passive management, on the other hand, simply invests in an index that measures the overall stock market, such as the S&P 500. In this arrangement, stocks are only bought when they are added to the index and sold when they are removed from the index. In this way, passively managed index funds mirror the index they are based on, and since indexes such as the S&P 500 essentially are the overall stock market, you can invest in the overall stock market over the long term by simply buying and holding shares in an index fund.

If you do have a sizable amount of money with which to begin your retirement fund and are comfortable picking your own investments, you could realistically build your own diversified portfolio. For example, if you wanted to invest your retirement fund in stocks, you could buy about 20 stocks, a few from each economic sector. Provided none of the companies in your portfolio are related, you should have a good level of diversification.

The bottom line is, no matter how you choose to diversify your retirement holdings, making sure that they are properly diversified. There is no exact consensus on what number of stocks in a portfolio is required for adequate diversification, but the number is most likely greater than 10, and going to 20 or even a bit higher isn't going to hurt you.